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December 03, 2007

The Next Big, Big Crack

We have, it seems, evolved a political/media system that nearly guarantees no remedies until the damage has been done, the scoundrels have safely buried the loot, and there is a full blown crisis on hand. It's not just the politicians out there running reverses and repeating tired saws that negate even their own private thoughts; it is also the media pundit chorus, people purportedly paid to do some quality thinking who, it seems. all too often forget how little they really know.

We got back to the States two weeks ago, in time to hear the weekend bloviators indicate almost unanimously that Hillary Clinton had wrapped up the Democratic presidential nomination.  Only on the following Monday when an ABC Washington Post poll came out of Iowa were they stunned into realizing that all of their hot air and spin had to be revised.  Somehow, Iowans --the folks who actually will be making up their minds in 5 weeks-- had, like their credit cards, maxed out on Hillary's message of a return to the good old days. 

What Don't They Miss?

Pundits, of course, travel on other peoples' credit cards and sometimes even get to dine and rub shoulders with the Great Gatsby crowd that have had a great run these last few years. For them, the sound and smell of little people's mortgages going up in smoke is as far away as one of Jupiter's liquid moons. Nothing it seems can divert their eyes from the talking points coming across the transom, not even the unseemly multibillion dollar panhandling in Arabia of giant financial institutions --Bear Stearns, Merrill Lynch, Citibank, Bank of America, HSBC, to name a few- as stoppers to the hundreds of billions of dollars in write-downs they are taking for holding derivatives (many of their own making-- that were somehow supposed to have allowed them to sprinkle fairy dust on the toxic waste they'd bundled into tidy CDO's, CLO's, MBS's, etc.)  (For a lot more detail on this alphabet soup mess, please have a look at our July 27 piece The Big Crack )

That trillions of dollars have flowed out of the US and into the coffers of sheikdoms small and large, friend and foe, as well as to our East Asian allies and rivals is something best left to the money men to figure out, it seems.  Even when great banks teeter on the brink, and CEO's are forced packing, we hear nary a peep out of the political and media class.

Does anyone among the poobahs and sages wonder how it is that nearly all these so-called sophisticated money men, and their peanut counters in the back room bought so heavily into their own waste product?  Or in the more convoluted case of Goldman Sachs, shorted the lousy paper they were selling to their best customers (even while the present Secretary of the Treasury was still leading the firm)?

Hardy, though Paul Krugman, the Princeton economist and New York Times columnist, who does do his own thinking, had a simple way of nailing it; greed in the corner office in a political environment that has put the foxes in full control of the henhouse. Krugman has made the Enron-revisited point that none of the CEO's who've lost their jobs as the multibillion dollar losses of the subprime crisis have hit the fan, has had to give back his golden parachute going forward or the obscene, bonus-based, pay packages they collected during the years they were ginning up the phony mortgage market and creating the mountains of bad paper --they secretly called "toxic waste"-- their institutions and stockholders are now forced to swallow and that is shaking world financial markets.

The Farce Begins

The Friday November, 30th Wall Street Journal reports that the Bush Administration --the same guys who advocated that Social Security should be replaced by private investment accounts in the markets-- is in the process of negotiating with the banks with an end result that is sure to mean --even if its hidden in the deal-- that the taxpayers will soon be subsidizing the banks as well.

Here's a good pundit question to be asked: Will the Democratic Congress ratify a deal designed to help the banks and the holders of some of the many balloon mortgages that are scheduled to blow up as rate increases kick-in, without asking that at least some of those bank and hedge fund executives who have pulled in billions of dollars in bonuses for the last few years to give back any of their bonuses and commissions, in return for a rescue of their scams?

We, here in Dymaxia, are willing to bet that the question will hardly arise before it gets buried like a lead pipe in a toxic waste dump.  After all, this sitting Congress already has a record on hedge fund bonus money; i.e., they continue to allow it to be called "capital gains" by the hedge fund moguls, so it can be taxed at 15%, half the rate the folks who sweep their offices pay on their earnings!

But bank sub-prime paper mega-write-downs (see the E*Trade deal where $3 billion in CDOs was turned overnight into $800,000, for instance)   also strike at lots of folks who have pensions invested in the banking industry not to mention bank stocks in their mutual fund portfolios. In the case of Citigroup (CIT), alone, shareholders have, since the beginning of the year, lost approximately two thirds of the value of their holdings, or more than $80 billion dollars. In E*Trade's (ETFC) case, shareholders have lost more than three-quarters of their holdings.

CIT is, or was, of course the world's largest financial institution. In desperation, to stay above water it negotiated a deal in which it promised to pay its rescuer, the Abu Dhabi government, 11% interest on the $7.5 billion cash injection it received this week. In today's world where very big money accrues even to individuals if they're in the right place, $7.5 billion probably doesn't sound like a lot to a pundit's ear.  It was, it turns out, enough to buy nearly 5 percent of our biggest bank.  Importantly, for the gulf state oil sheikdoms, it represents probably only a few-day flow of petrodollars; here, it seems, the pundits and the petro-billionaires can agree!

Trillions of dollars, of course, is real money even in Washington where they print the stuff.  No one knows where it all goes except when big purchases become visible like the Chinese attempt to buy a large oil company with significant reserves or when the management of our major ports goes on the block. What the Citigroup deal points out is that these outside government and quasi-government players in the Gulf States (including Saudi Arabia, of course), China, and Russia are likely to continue to gain clout as the major tectonic shifts of the current crisis continue to shake the banking system.

Now, imagine for a minute that subprime mortgage based money creation was not an anomaly and that there are parallel but even larger fault lines still to come into play!  Impossible, you say?

Here's the way it works when the Fed and the regulators are betting on the private sector to regulate itself: banks and their proxies earn immediate money by lending time bombs that don't go off for several years; bigger banks and hedge funds earn money on these foolish loans by packaging them and turning them into respectable derivatives they sell without, in many cases having to pay a middle man or market fee directly to their customers; rating companies profit by this new business stream and give out their imprimatur of a high credit ratings to this paper now three steps removed from the original loan; other banks and insurers serve as counterparty guarantors, buying and selling the obligations as investment grade to their customers or hold as reserves, thereby "spreading the risk" eventually around the globe.

Are Junk Bonds the Next Junk Bombs?

When it became clear last summer that the entire world banking system had been gaming itself as the US home mortgage bubble reached gargantuan proportions, politicians and their sock puppets looked the other way, spouting the usual nonsense about the core economy being sound.  Neither party could see perils without an equal mix of good news in dealing with the crisis.

Now that the problem has spread beyond the growing rash of foreclosures (these only affect ordinary people and are thus ..........) and to the foundations of the major banks thereby threatening pension funds and even bank deposit holders, the problem still gets less notice by the commentators than the daily swings of the Dow Jones Index.  It's almost as if on the day the twin trade towers fell, the stock market stayed open and went on to gain a couple of hundred points so the headlines read: "Despite Early Fall, Markets up on Gains in Scrap Metal, National Security and Office Building Prospects".  The Dow Jones Index now seems to be the only gauge the media use to measure events on the ground.

Official Blindness

Pundits are an important component of the information flow, since they shape public opinion; so how they get spun matters much. Politicians, we know, who get out in front of public opinion face ridicule and sudden death, which is probably why there are mere nuances of differences in the platforms of all the Democratic candidates, minus say, Kucinich and for all the Republican's, Ron Paul. The pundits, as we noted, tend to read each other, hoping, one supposes, that one among them knows something. The rest of the time they rely upon being fed thought aids by the lobbyists and other operatives, the guys who earn the big bucks in Washington.

Unlimited Dollars All Around

Public money used to have meaning in Washington until Ronald Reagan intuited that debt, in our new economy, had become as American, say, as a wallet full of credit cards. Take the 5th year of the Iraq Occupation. The United States continues to spend off budget nearly 10 billion dollars a month on Iraq, or, in annual terms, nearly one percent of our entire annual gross national product.  To make this palatable, the Administration has raised no taxes but preferred to merely further run up our national debt, something it has been doing across the board without much pushback, anyway.

As we've often pointed out here in BlowBack, since Bretton Woods, the US has had a built-in cushion that allowed it to spread its debt practically cost free around the world. The privilege, a massive type of seigneurage, was made the base of a system in which dollars printed here and spent to buy foreign goods and services often don't show up for payment but instead get held by other countries as a Reserve Currency  It's a great benefit that any country would be envious of; nonetheless, there can be too much of a good thing; the system has been allowed to perpetuate right into this massively financial global era, allowing trillions of dollars to build up outside the country in the last few years as China and petrodollar debts mounted geometrically.

Now that there are these trillions of dollars out there, it doesn't take a perfect storm scenario to imagine what kind of an avalanche a real crack here --say, a major bank or brokerage going under, might set off! China and oil producing nations, should more bad paper start to unwind, might be tempted to cut their losses and try to recycle those dollars into "real" investments, like shares, say, in hat in hand banks or teetering corporations or in the holders of natural resources..

It now looks like one indirect result of the Iraq adventure will be the future dismantling of Bretton Woods.  Since Bush took office the dollar has lost more than half of its value if gold, oil or other raw materials, including food grains) are used as a counter value. 

Our pundit class, of course, never mentions the actual financial cost of the occupation, even as many of them advocate stretching it out as far as the eye can see, once again imagining that the US can go on printing dollars indefinitely just like in the good old days.

But this level of obliviousness, unreality and folly is, of course, hardly limited to the falling dollar, the collapsing mortgage market, the strains showing in the banking system from Citibank to E-Trade or even the looming recession.

CDS, the Next Dominos, Junk Bonds and Counterparts

To get to the Perfect Storm scenario, another shoe might have to drop and it looks like junk bonds may very well be the next subprimes:

This week, we read a compelling piece on where the next big crack might occur, thanks to the research of Ted Seides, as republished by John Mauldin in his Nov 26th "Outside the Box" weekly e-letter.  Seides  entitled his essay The Next Dominos, Junk Bond and Counterpary Risk. In his article, Seides makes the point that the total amount of derivatives issued by the financial institution bundling mortgage debt, pales in comparison with the amount of deriivatives (CDS) that are in circulation, built not on mortgages but around corporate Junk Bonds, which, he points out, are by definition are high risk vehicles.

According to Seides, there are $45 trillion (yes, trillion with a T or more than three years of US GNP) of these derivatives sitting on the balance sheets of financial institutions around the world. He also makes the searing point that there are no reserves (or counterparts, as he calls them) to back these CDS's up. The issuing banks and hedge funds are the guarantors and they have not been required to set any countervailing funds aside to support the paper they've issued.

Here are a selection of attention-grabbing quotes from Seides piece that, unfortunately does not appear to be available on line, yet:


The amount of outstanding corporate credit and leverage applied to it (the CDS market) dwarfs the market for subprime mortgages. As such, the consequences of a problem in this arena may be far more severe than what happened in subprime. If we are going to experience the downside of another economic cycle, we may be in for a painful ride.


One way of thinking about the CDS market is that of a huge, new insurance industry whose providers reserve nothing for future losses. Imagine what would happen if $45 trillion worth of insurance policies experienced an actuarial average of 5% losses and no one had $2.25 trillion sitting around to foot the bill!


High-yield bonds are dubbed junk for good reason. Corporate mortality tables indicate that defaults of high-yield bonds within five years of issuance occur 28% of the time for those just below investment grade and 47% of the time for those with the lowest ratings. Past instances of high default rates lagged periods of strong junk issuance by 4 to 5 years, coinciding with recessionary periods in the economy.


Making matters worse, approximately one-third of all outstanding, single-name CDS are derivatives of credits with ratings below investment grade. When investors have insatiable appetites for yield, the food stinks, compensation for it comes in small portions, and customers still can't get enough.

Does this all sound familiar?  It should if you've followed the sub-prime debacle!


The Black Swan in the Room

We take our lead from Nassim Nicholas Taleb, mathematician, empiricist and trader, who can be fairly ranked as one our worthiest contemporary anti-pundits. NNT, as he likes to refer to himself is, most recently, the author of The Black Swan, The Impact of the Highly Improbable.  In this book and others, Taleb argues that contrary to the thinking of the punditry, or all those who would predict the future based on the norms of the past, randomness plays a much greater role in the outcome of history than is even vaguely appreciated by those whose world is routinely described by the bell curve of probabilities. For Taleb, it's not just that backward looking statistics lie but when it comes to seeing what might lie ahead, they are as useless as an ice cube in hell.

The Black Swan is, of course, his metaphor, for something that is totally unexpected  (by all, but those close to it, and even they often don't realize the true extent --remember Watson, the founder of IBM predicted there might be a market for four of his machines!) until it is actually developed and injected into the system. In the world of mediocrity, the land of the pundits and politicians, there are no black swans but, as NNT points out, we do not live in "Mediocristan" but instead in "Extremistan". Taleb, of course, can easily point to a string of even recent developments that have appeared "unexpectedly" that have radically and irreversibly changed the way the world functions, from central processing computer chips to the Internet, to mobile phones, (to, yes, the subprime loan debacle that was on no MSM analyst's radar up to just a few months ago), etc.

Mediocristan or Extremistan?

As we've said often in these pages, it sure doesn't look like Mediocristan out there as we watch the markets jerk up and down like vaporetto commuters in Venice, even as we watch the bailouts big and small at banks all over the globe and as we mull over all those unregulated hedge funds --the new counterparties-- going after "absolute profits" for themselves and their clients.

In Mediocristan it all shakes out, reason trumps greed and the beat goes on,,lati lati do!  

Posted by dymaxion at 05:03 PM

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